LawFlash

Next Round for the Financial Reform Bill: Significant Broker-Dealer and Investment Adviser Issues Go to the Senate and House Conference Committee

June 14, 2010

On June 10, 2010, a Conference Committee of the United States Senate and House of Representatives convened for the purpose of reconciling the “Restoring American Financial Stability Act of 2010” passed by the Senate on May 20, 2010 (the “Senate Bill”) and the “Wall Street Reform and Consumer Protection Act of 2009” passed by the House on December 11, 2009 (the “House Bill”). The Senate and House Bills vary in certain important respects, but overall the bills take similar approaches to reform of the regulation of financial markets and market participants. Below we highlight seven key areas in the proposed legislation that could significantly impact broker-dealers and investment advisers.

Volcker Rule. The Senate Bill includes the “Volcker Rule,” which would impose a blanket prohibition on most proprietary trading by U.S. banks and their affiliates (including broker-dealers) with only limited exceptions. The House Bill includes a provision that would allow the Federal Reserve to address the proprietary trading issue at certain systemically important financial institutions in certain circumstances. The Volcker Rule also would ban covered institutions from sponsoring or investing in hedge funds or private equity funds.

Broker-Dealer Fiduciary Duty. The Senate and House Bills would take very different approaches to the issue of a fiduciary duty for broker-dealers when advising retail clients. The Senate Bill would require an SEC study on this topic while the House Bill would require the SEC to adopt rules imposing a fiduciary duty on a broker-dealer when providing any personalized investment advice to a retail customer.

Registration for Advisers. The Senate Bill would broaden the class of investment advisers required to register with the SEC, and expand certain recordkeeping and recording requirements to provide authorities with data to assess the level of risk to the stability of the U.S. financial system. The Senate Bill would exempt advisers to venture capital funds, family offices and certain “foreign private advisers” from registration, recordkeeping and reporting requirements. Advisers to private equity firms also would be exempt from registration but would be subject to recordkeeping and reporting requirements.

Derivatives Regulation. The Senate and House Bills would effect a complete overhaul of the regulation of the derivatives market. An extraordinary amount of rulemaking by, among others, the CFTC and SEC will be required to implement the legislation. If implemented, the legislation would radically change the way in which mutual funds, hedge funds, banks, broker-dealers and end-users trade derivatives.

Changes to Regulation D. The Senate Bill would direct the SEC to exclude the value of an individual investor’s primary residence from his or her net worth for purposes of determining whether he or she qualifies as an “accredited investor” for purposes of the Regulation D private placement exemption under the Securities Act of 1933, as amended (the “1933 Act”).

Predispute Arbitration Clauses. The House Bill would give the SEC authority to prohibit or limit mandatory predispute arbitration clauses in contracts between broker-dealers, municipal securities dealers, investment advisers and their clients. The Senate Bill also would give the SEC the authority to prohibit, limit or reaffirm such mandatory predispute arbitration clauses.

SEC Enforcement. The House Bill would expand the scope of the SEC’s enforcement tools; the Senate Bill would provide for SEC self-funding which likely would allow the SEC to expand its enforcement capacity.

The Volcker Rule’s Prohibition on Proprietary Trading and on Sponsoring or Investing in Hedge Funds

The Senate Bill includes the Volcker Rule, which would significantly limit proprietary trading1 by banks and their affiliates, and would prohibit banks and their affiliates from owning, operating or sponsoring hedge funds or private equity funds. The House Bill includes a more limited provision that would allow the Federal Reserve to address the proprietary trading issue at certain systemically important financial institutions in certain circumstances.

The Senate Bill would except from the proprietary trading ban any trading by a bank or its affiliates on behalf of a customer, as part of market-making activities, or otherwise in connection with or in facilitation of customer relationships, including risk-mitigating hedging activities. The task of determining what constitutes proprietary trading and what fits within the market making, customer facilitation or hedging categories would be left to the regulators. Needless to say, that determination is critical to the impact this rule would have on broker-dealers, banks and the trading markets generally. Also excepted from the proprietary trading ban is trading in certain governmental and agency securities and proprietary trading by a non-U.S. company not controlled by a U.S. company that occurs solely outside of the United States.

The Senate Bill also would prohibit almost all banks and their affiliates from sponsoring or investing in hedge funds or private equity funds.2 Activities that constitute “sponsoring” include “serving as a general partner, managing member or trustee of the fund; in any manner selecting or controlling. . .a majority of the directors, trustees or management of the fund; or sharing with the fund. . .the same name or a variation of the same name.” The Senate Bill, however, would allow investments in small business investment companies and investments designated primarily to promote the public welfare and also would allow non-U.S. companies that conduct business solely outside the United States that are not controlled by a U.S. firm to invest in or sponsor hedge funds or private equity funds.

The Senate Bill directs a new interagency financial stability oversight council (the “Council”) to complete studies on the proposed impact of the Volcker Rule within six months of the law’s enactment, and to make recommendations for implementing the section, including any modifications to definitions or activity limits. The Council’s authority to modify the rule is very limited, however, and would not allow the Council to make fundamental changes to the proposed activity limits. In addition, the appropriate federal banking agencies would be required to promulgate final rules to implement the activity and concentration limits of the Volcker Rule within nine months of the study’s completion. Firms within the scope of the Volcker Rule’s authority would have two years after the issuance of these regulations to come into compliance with the activity limits, but could receive up to three one-year extensions from the appropriate federal banking agency.

Fiduciary Duties for Securities Brokers

The House Bill would impose fiduciary duties upon securities brokers when they are providing personalized investment advice to their retail customers. The Senate Bill would not. Rather, the Senate Bill would first require that the SEC study on the effectiveness of existing standards of care relating to the provision of personalized investment advice and recommendations about securities by broker-dealers and investment advisers.

The Advisers Act currently excludes from the definition of investment adviser brokers’ advisory activities that are solely incidental to brokerage activities and for which they receive no special sales compensation. The House Bill would remove this exclusion when a broker-dealer provides personalized investment advice to its retail investors.

By contrast, the Senate Bill calls for the SEC to conduct a one-year study on the effect of proposed changes to current standards of care imposed upon brokers, dealers, investment advisers and their associated persons who provide individualized securities advice to retail customers. If the study indicates that there are gaps or overlaps in the regulatory framework, then the SEC is required to begin rulemaking procedures to address those issues and promulgate rules under its existing statutory authority within two years. Several amendments were proposed in the Senate that would have imposed a uniform fiduciary duty upon broker-dealers and investment advisers — including at least one amendment that would have imposed a fiduciary duty not only in retail transactions, but in institutional transactions as well. While none of those amendments was brought to a vote before passage of the Senate Bill, we currently think that the final bill adopted by the Conference Committee is most likely to adopt a version of a fiduciary standard. However, the details and timing of implementing any related rules could be the subject of significant discussion in the Conference Committee.3

The Senate Bill would broaden the class of investment advisers required to register with the SEC, and expand certain recordkeeping and recording requirements to provide authorities with data to assess the level of risk to the stability of the U.S. financial system.

Like the House Bill, the Senate Bill would amend the Advisers Act to remove the exception for advisers with “fewer than 15 clients,” and (aside from an exemption for “foreign private advisers” discussed below) would provide no exception for funds created outside the U.S. or where U.S. citizens have less than a 10 percent ownership interest in the fund. The House Bill would exempt advisers to venture capital funds from registration, while the Senate Bill would exempt advisers to venture capital funds, private equity funds and small business investment companies. The Senate Bill also would exempt advisers to family offices. Under the Senate Bill, advisers to private equity funds, even if exempt from Advisers Act registration, would be subject to recordkeeping and reporting requirements; however, advisers to venture capital funds, family offices and small business investment companies would be exempt from those requirements. Although the House Bill exempts advisers to venture capital funds from registration, those advisers would still be subject to recordkeeping and reporting requirements to be determined by the SEC.

Although removing the exemption for advisers with fewer than 15 clients may tend to increase the number of investment advisers subject to Advisers Act registration requirements, a provision in the Senate Bill would raise the threshold of assets under management required for SEC registration from $25 million to $100 million. This would tend to reduce the number of investment advisers required to register under the Advisers Act, although investment advisers that fail to meet the increased threshold would need to consider whether they are required to register under applicable state laws. A similar provision in the House Bill proposes to raise the threshold for Advisers Act registration for investment advisers that act solely as advisers to private funds and have assets under management in the U.S. of at least $150 million. There is no provision in either Bill for grandfathering. Therefore, SEC-registered investment advisers with assets under management falling between $25 million and $100 million or, if applicable, $150 million, may be required to transition to state registration and regulation after the passage of the final bill.

Both the House and Senate Bills provide a one-year transition period before these registration requirements take effect; however, any adviser that would be subject to the new registration requirement may take steps to comply during the transition.

The Senate Bill also authorizes the SEC to impose new disclosure and recordkeeping requirements on registered advisers to private funds. (As noted above, advisers to private equity funds that are exempt from registration would also be subject to recordkeeping and reporting requirements as determined by the SEC.) These requirements would be designed to protect investors and the public interest and to provide the Council and its Office of Financial Research with the data necessary to monitor systemic risk issues. The SEC would receive broad authority to define its recordkeeping and reporting requirements, but the Senate Bill specifies that a fund’s records and reports would have to describe (1) the amount of assets under management and use of leverage; (2) counterparty credit risk exposure; (3) trading and investment positions; (4) valuation policies and practices of the fund; (5) types of assets held; (6) side arrangements or side letters, providing favorable terms for certain investors; (7) trading practices; and (8) all other information “necessary and appropriate” in the public interest and to protect investors and assess systemic risk. Although the SEC is directed to share with the Council all data necessary to the assessment of systemic risk, the Senate Bill also includes confidentiality provisions to safeguard proprietary information.

The Senate Bill would also codify the SEC’s authority to promulgate rules requiring registered investment advisers to take steps to safeguard client assets in an adviser’s custody. Although no specific measures are articulated in the Senate Bill, it would authorize the SEC to promulgate custody-related rules, such as, for example, requiring verification of custodial assets by an independent public accountant. The House Bill directs the SEC to adopt a rule requiring registered advisers to place any client accounts in excess of $10 million in the custody of a “qualified custodian,” who may not directly or indirectly provide investment advice with respect to those accounts. We believe the Senate Bill would not require the SEC to take any additional regulatory action beyond the Custody Rule amendments adopted at the end of 2009; however, the SEC likely would have to engage in addition rulemaking to address the custody-related provisions in the House Bill.

Both the House Bill and the Senate Bill exempt from Advisers Act registration requirements any adviser that is a “foreign private adviser.” The Senate Bill defines “foreign private adviser” as an investment adviser who (1) has no place of business in the U.S.; (2) has fewer than 15 clients who are domiciled in or are residents of the U.S.; (3) has less than $25 million of aggregate assets under management attributable to U.S. clients and to U.S. investors in private funds managed by such adviser (or such greater amount as the SEC may specify in a rule); and (4) neither holds itself out generally to the public as an investment adviser nor acts as an investment adviser to any (a) investment company registered under the U.S. Investment Company Act of 1940, as amended, or (b) business development company. The House Bill slightly narrows the “foreign private adviser” exemption by requiring the adviser to have fewer than 15 clients and investors in the U.S. in private funds advised by the adviser. Thus, the House Bill treats U.S. investors in private funds as U.S. clients for purposes of both the 15-client test and the $25 million in assets test, while the Senate bill applies this “look through” only to the $25 million in assets test. In addition, the House Bill includes a 12-month look-back requirement for purposes of both the fewer than 15 U.S. clients and investors test and the $25 million assets under management threshold. Since both the House Bill and the Senate Bill treat U.S. investors in a private fund as U.S. clients for purposes of the $25 million in assets test, it is likely that the proposed new legislation will require many non-U.S. hedge fund managers to register under the Advisers Act if their funds accept investments from U.S. investors.

Derivatives Regulatory Reform

The derivatives market will undergo a complete overhaul if the proposed legislation is enacted. Much is unclear regarding how the regulatory structure will actually work (or whether in fact it will work). Significant and cooperative interagency rulemaking will be required by, among others, the CFTC and the SEC, relating to nearly every aspect of derivatives trading. The basics of the proposal include:

The SEC is given jurisdiction over security-based swaps and the CFTC is given jurisdiction over most every other swap and related product4

Swap dealers, “major swap participants,” derivatives clearing organizations and swap execution facilities5 will be required to register with the CFTC and/or the SEC

Registered entities will be subject to margin and capital requirements and regulatory oversight, all to be determined

Swaps that are accepted for clearing by a clearing house will be required to be cleared, with some exceptions

Cleared swaps that are made available for trading on an exchange or a swap execution facility will be required to be so traded

Swap participants must disclose swap positions and trading information to the regulators and, where deemed appropriate, to the markets

The derivatives sections of the Senate and House Bills are generally similar, although there are a number of important distinctions between the bills. Among the differences is that the Senate Bill contains the so-called Lincoln Amendment, which effectively would require bank holding companies to conduct their derivatives trading operations outside of their banks; the House Bill contains no similar provision. Lawmakers and regulators have taken the view that the Lincoln Amendment goes too far and that the Volcker Rule (discussed above) achieves a similar effect in a less obtrusive way. The Senate Bill imposes a fiduciary duty on swap dealers when transacting with entities such as municipalities and pension plans, and the House Bill has no similar provision. This rule, if enacted, could have the effect of preventing these entities from accessing the derivatives market.

There are significant issues as to the effect the legislation would have on swaps entered into before enactment. It is clear that pre-enactment swaps are exempted from the clearing requirement, provided that the positions are reported. There is some question as to whether margin and other rules may be imposed on pre-enactment swaps, which has been the subject of serious debate and concern among market participants.

The legislation may add significant cost and reduce flexibility for mutual funds, hedge funds and other active derivatives users in hedging risk through the derivatives markets. In addition, the derivatives activities of certain non-dealers may put them in the position of being defined as a major swap participant and subject them to the capital, margin and regulatory oversight that accompanies that status.6 Separately, both bills require swap dealers to segregate collateral posted for uncleared swaps if requested by their counterparties, which will likely raise costs for dealers (and perhaps their counterparties) but may provide a degree of safety to end-users.

Until the bill passes in its final form and the regulators begin promulgating rules to implement the legislation, uncertainty is the order of the day in the derivatives markets.

Proposed Amendments to Regulation D “Accredited Investor” Definition

The net worth threshold for “accredited investors” is detailed in Regulation D under the 1933 Act, and includes “a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase.”7 The Senate Bill would direct the SEC to amend the Regulation D to adjust the $1 million net worth threshold for accredited investors to exclude the value of the investor’s primary residence. The House Bill would make no adjustments to the definition of “accredited investor” in Regulation D; however, it would require the SEC to adjust for inflation the net worth and assets under management tests of the “qualified client” standard for purposes of the exemption from restrictions on performance-based advisory fees under Rule 205-3 of the Advisers Act, and as a result, raise the threshold for clients who may be charged performance fees. The House Bill would require the SEC to adjust the qualified client standard for inflation within one year on the law’s enactment, and readjust it every five years.

The Senate Bill would direct the SEC to maintain the net worth threshold at $1 million exclusive of the value of the investor’s primary residence for four years after enactment of the law. The Bill also would authorize the SEC to review the definition of accredited investor as it applies to natural persons and to promulgate rules adjusting the provisions of the definition — including the requirement that an individual have income exceeding $200,000 or $300,000 in income for couples — except with regard to the revised net worth test. After the first four years following enactment—and at least once during every subsequent four-year period — the SEC is required to review the definition of accredited investor as it applies to natural persons, including the net worth standard, to determine if the definition should be adjusted as appropriate for the protection of investors, in the public interest, and in light of economic conditions.8

Mandatory Predispute Arbitration Clauses

Both the House and Senate Bills would give the SEC authority to prohibit, limit or condition mandatory predispute arbitration clauses in contracts between customers, brokers, dealers and municipal securities dealers, and contracts between investment advisers and customers arising under the securities laws or the rules of a self-regulatory organization. Both bills would provide for this authority to be used “in the public interest and for the protection of investors”; however, neither bill includes a timeframe for rulemaking on the issue, or would require the SEC to promulgate any rules on these arbitration clauses. Although the difference between the House and Senate Bills appears largely semantic, the House Bill would grant the SEC authority to “prohibit or, impose conditions or limitations” on mandatory predispute arbitration agreements; the Senate Bill would allow the SEC to “reaffirm or prohibit, or impose or not impose conditions or limitations” on mandatory predispute arbitration clauses. Although the House Bill does not explicitly provide authority to reaffirm mandatory predispute arbitration clauses, the SEC could effectively do so by declining to exercise its authority to prohibit, limit or impose conditions upon them.

The House Bill also would provide the Consumer Financial Protection Agency (the “Agency”) with the authority to limit or ban mandatory predispute arbitration clauses in consumer financial contracts. By contrast, the Senate Bill would merely authorize the Consumer Financial Protection Bureau (the “Bureau”), to conduct a study on the issue before the Bureau could limit the use of mandatory predispute arbitration clauses. Should the Bureau or Agency adopt rules to ban or limit mandatory predispute arbitration agreements in the consumer context, such a decision would place considerable pressure on the SEC to adopt similar rules for broker-dealers and investment advisers.

Neither the House nor Senate Bill would extend the Bureau or Agency’s reach to securities products. However, the Bureau or Agency will have authority with respect to non-securities products (such as mortgages) offered by broker-dealers and investment advisers, and the allocation of examination and enforcement responsibility between the SEC and the Bureau or Agency is not clear. Further, it is likely that the lines of authority with regard to certain products will require time to sort out, particularly when securities and non-securities products share characteristics or are offered as alternatives to achieve the same financial objectives.

Whistleblowers, SEC Enforcement Tools and Proposed SEC Self-Funding

Both the House Bill and the Senate Bill would expand the incentives for whistleblowers to report evidence of securities law violations. The two bills would authorize the SEC to reward whistleblowers for reporting violations of any securities law (rather than just for insider trading violations, as is currently the case), and to increase from 10 percent to 30 percent the maximum reward that whistleblowers can recover when the SEC imposes sanctions on violators. Both Bills also would provide a cause of action to any employee against an employer for any conduct in retaliation for any whistleblowing activities related to securities law violations.9

The House Bill also would expand the set of enforcement tools available to the SEC; however, the Senate Bill has not followed suit. The House Bill contains two key SEC enforcement measures that are not in the Senate Bill. First, the House Bill would authorize the SEC to seek civil monetary penalties in administrative proceedings, instead of federal district court, not only against broker-dealers and investment advisers (as is currently the case), but against anyone, including public companies and officers and directors. Second, the House Bill would grant the SEC access to grand jury materials — currently only available to prosecutors. The House Bill also contains provisions relating to aiding and abetting and control person liability, and extraterritorial jurisdiction that are missing from the Senate Bill.

The Senate Bill would empower the SEC to become a self-funding entity, with the authority to set its own budget outside of the congressional appropriations process, although we understand that some Senate Republicans object to this proposal. The House Bill authorizes a larger budget for the SEC and would allow the SEC to impose fees on investment advisers to fund an expanded examination program; however, the SEC’s budget would still be subject to the appropriations process. One likely practical result of the Senate Bill would be to disband the SEC’s Office of Compliance, Inspections and Examinations (OCIE), as the Senate Bill would provide the Division of Trading and Markets and the Division of Investment Management with a staff of examiners to perform compliance inspections. The House Bill does not include this provision.10

Next Steps in Congress

A number of significant issues remain to be resolved in the Conference Committee. The debate over aspects of derivatives regulation may have implications for the Volcker Rule. The Lincoln Amendment in the Senate Bill would effectively require bank holding companies to operate their swaps desks outside of their banks — a provision opposed by Chairman Bernanke, Secretary Geithner, Rep. Frank and Senate Banking Committee Chair Sen. Christopher Dodd (D-Ct.), among others. Although the Lincoln Amendment may not survive to the final bill, its inclusion in the Senate Bill appears to have moved lawmakers toward accepting broader prohibitions on proprietary trading than those proposed in the House Bill.11

There appears to be high-level agreement on the major issues of the legislation, including consumer protection, resolution authority for financial institutions and “too big to fail.” In many areas, however, the details of the compromise remain to be determined. Rep. Frank has stated his intention to present a bill for the President’s signature by July 4; however, President Obama has since expressed his desire to receive the bill before the G-20 summit towards the end of June.

Conclusion

Broker-dealers and investment advisers would be well-advised to pay attention to the congressional debate over financial reform in the next several weeks. Although much of the debate still may focus on issues such as “bail-out” and too big to fail, issues of interest to broker-dealers and investment advisers, generally and as affiliates of banks and bank holding companies, will likely be addressed. The final bill to emerge from the Conference Committee is likely to change fundamentally the way that many financial institutions, including broker-dealers and investment advisers, conduct their business.

1The Senate Bill defines proprietary trading as, “purchasing or selling, or otherwise acquiring or disposing of, stocks, bonds, options, commodities, derivatives, or other financial instruments . . . for the trading book [of the company] or such other portfolio as the Federal banking agencies may determine. . . .”2The Senate Bill also would subject bank holding companies and their subsidiaries that serve directly or indirectly as managers or investment advisers to a hedge fund or a private equity fund to the strictures on transactions between affiliates that are codified in Sections 23A and 23B of the Federal Reserve Act.3The Senate Bill would create an Investor Advisory Committee and an Office of the Investor Advocate at the SEC. These bodies would represent the interests of individual investors and state securities commissions within the SEC.4There is a question as to whether certain foreign exchange swaps will be covered by the regulation.5The definitions of “swap execution facility” in the two bills differ in important respects. 6The definitions of “major swap participant” in the two bills differ in important respects. 715 U.S.C. § 501.8The Senate Bill also requires that the GAO conduct a study on the appropriate criteria for determining the financial thresholds needed to qualify for accredited investor status and eligibility to invest in private funds. The Senate Bill calls for this report to be submitted to the appropriate House and Senate committees within three years of the law’s enactment.9Both bills also would expand the scope of collateral bars to prevent securities law violators from associating with any SEC-regulated firms. Current law bars offenders from associating only with those firms regulated by the specific provision violated. 10The Senate Bill would require a series of reports from the SEC and GAO to Congress regarding SEC management, personnel and financial issues. The Senate Bill would authorize numerous additional studies of interest to broker-dealers and investment advisers. We would be happy to provide a list upon request.11See Damian Paletta and Victoria McGrane, “Frank Targets Requirements to Spin Off Operations,” Wall St. J. (May 26, 2010)(http://online.wsj.com/article/SB10001424052748704026204575266300665355526.html).